The Transmission Mechanism of Monetary Policy in Emerging Market Economies - Part: 5
[An Overview of the Discussion Papers Submitted by the Basel Policy Group - Overview by Steven Kamin,
Philip Turner and Jozef Van 't dack - The Orgnal Article may be referred at - URL http://www.bis.org/publ/plcy03.htm]

Leveraging and net worth

As already noted, the strength of balance-sheet positions is likely to be an important determinant of borrowing and spending, insofar as it affects both permanent income and financial vulnerability. The relationship between balance-sheet strength and financial vulnerability, and therefore between balance-sheet strength and expenditures, is likely to be nonlinear. When initial balance-sheet positions are strong - that is, assets far exceed debt repayment obligations - the probability of future financial distress may remain low even after a marked reduction in the value of asset holdings, and therefore expenditures may be little affected. But if balance-sheet positions are weak, the same reduction in asset values may significantly boost the probability of insolvency or illiquidity, and therefore lead to a sharp and sudden adjustment to borrowing and spending. The initial financial condition of households and firms thus represents a key determinant of the impact of monetary policy. The stronger the initial position of balance sheets, the weaker will be the contribution of this channel to the impact of monetary policy on consumption and investment. In addition, the smaller the share of net debt (interest-bearing liabilities minus interest-bearing assets) in household and firm portfolios, the smaller will be the cash-flow effects of a given change in monetary conditions.

Various indicators could capture the vulnerability of the non-financial sector to different means by which balance-sheet changes affect spending. Unfortunately, very few countries (industrial as well as developing) collect the necessary statistics to allow the derivation of such ratios. One important measure is net worth, the ratio of net assets to income, which through standard neoclassical effects is expected to influence expenditures, even in the absence of concerns over debt repayment and financial distress. Another is the ratio of debt to assets which measures leveraging and may be better correlated with the probability that households or firms will have difficulty meeting scheduled debt service obligations. Insofar as interest payments on debt are likely to move more closely with changes in policy interest rates than returns on assets, the degree of leveraging also indicates the prospective size of the cash-flow effect resulting from monetary policy measures. However, the latter effect would be more precisely captured by a third indicator, the ratio of net interest payments to income.

As a result of financial liberalisation, the private non-financial sector has had more access to credit as public sector use of bank credit has fallen and capital inflows have risen: this implies that, as in the industrialised countries, various measures of balance-sheet vulnerability to monetary policy actions are likely to have increased in emerging market countries inthe past decade.

One implication of the non-linear relationship between balance-sheet positions and expenditures is that the effects of monetary policy will depend not only on the aggregate balance-sheet position of the nonfinancial sector, but also on its distribution among households and firms. If the financial condition of enterprises in an economy is very dispersed (some strong, others weak) the non-linearities between balance-sheet strength and spending will make the effects of monetary policy much more unpredictable than where most firms have rather similar balancesheet positions. Aggregate measures of financial positions may therefore be misleading.

The financial condition of the banking system is an important determinant of the cost and availability of bank loans. Declines in risk-adjusted capital/asset ratios can lead banks to limit lending by raising both interest rates and loan-qualification standards. As in the case of firms and households, the weaker their financial position, the more likely banks are toreduce loan supply as monetary policy tightens. When bank capital is high relative to assets, reductions in asset value (due to declines in securities prices or increases in non-performing loans) may still leave capital/asset ratios at comfortable levels. When initial capital/asset ratios are low, however, policy-induced increases in the cost of funds, declines in asset prices and deterioration in loan performance may force banks to sharply restrict loan availability, inducing a credit crunch that reinforces the effect of monetary policy in raising the cost of borrowing to households and firms.

Various developments over the past decade have accentuated the vulnerability of banks in emerging market economies to financial distress, and hence increased the sensitivity of bank lending to monetary policy. Macroeconomic misalignments and their delayed correction have been a major source of disturbance. Secondly, the reduced dependence of the banking system on government support, both through privatisation and the reduction of subsidies, has made capital/asset ratios for banks more binding than in the past. Thirdly, financial liberalisation and reduced fiscal deficits have encouraged a marked shift in bank lending from the public sector to the private sector. Because banks in many emerging market countries had limited experience in private loan assessment and monitoring, and because prudential oversight mechanisms were not sufficiently strengthened, loan quality deteriorated. Finally, this tendency has been reinforced by large-scale capital inflows, which caused the supply of loanable resources to increase faster than banks could properly allocate. Two summary measures of banking sector financial strength (the ratio of non-performing to total loans and the capital/asset ratio) are shown in Table 16.

Discerning whether there has been a credit crunch or not depends on distinguishing between declines in loan supply and declines in loan demand as explanatory factors for the reductions in lending that typically have accompanied recessions. Attempts to identify significant effects of a credit crunch in both the weak 1990-91 recovery in the United States and the Japanese recession of the 1990s have met with only mixed success. The decline of bank lending in Mexico in 1995 has been subject to less formal analysis, but again there is disagreement as to how far the huge drop in real credit outstanding reflected the response of bank loan supply to widespread financial fragility in the economy in general, and the banking sector in particular, and how far the response of bank loan demand to high interest rates, economic recession and weak balance sheets. Similar observations could be made for Russia, where the sizable share of idle assets in banks' balance sheets could be due to both the financial problems of enterprises and the extensive bad loan portfolios of banks. The distinguishing line between the fragility of banks and that of borrowers as the primary cause of tighter credit availability is also difficult to draw in the cases of Brazil and Thailand.

One difficulty in identifying significant contractionary pressures from a credit crunch - that is, a tightening of loan supply induced by a weakening of bank balance sheets - is that even healthy banks will react to a tightening of monetary policy and a subsequent slowing of economic activity by raising loan rates and loan standards. This in practice blurs the distinction between loan supply and loan demand. However, emerging market economies may be more exposed to a credit crunch than industrial countries because they are more dependent on bank financing.

There are four important aspects of the monetary transmission process where uncertainties and/or disagreements are especially deep, namely (i) the transmission of monetary policy actions to long-term interest rates and asset prices, (ii) gauging the tightness of monetary conditions, (iii) the scope for monetary policy under fixed exchange rates and financial fragility, and (iv) the effects of monetary policy in high-inflation economies. In all cases, the state of expectations very largely conditions the impact of monetary policy, and it is this which gives rise to the uncertainties.

[Note: These four aspects are not dealt with in detail in this module.]

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